“Ask the Business Attorney” – What Are the Biggest Legal Mistakes that Startups Make?

by Scott Edward Walker on June 9th, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of the most popular websites for entrepreneurs). Below is a longer, more comprehensive version — with ten mistakes, instead of six.

Question

My buddy and I are coding up a new site and we will be ready to launch the beta in about a month. We have a couple of angel investors who are interested, and we don’t want to screw anything up. What are the biggest mistakes that you’ve seen guys like us make?

Answer

Here are ten quick ones (in no particular order):

1. IP Ownership. Some entrepreneurs make the mistake of creating IP for their new venture while they are still working for someone else. They then quit and launch their startup, not realizing that the IP is actually owned by their prior employer. This is a tricky issue, and you should carefully review all employment-related agreements to determine if there are any provisions that may inhibit your new venture, including IP ownership. I discuss this issue in detail in paragraphs 2 and 4 of my blog post regarding formation issues (part 2).

2. Choice of Entity. Some entrepreneurs make the mistake of forming the wrong entity. Investors generally invest only in corporations – not LLC’s or partnerships. You should thus form a corporation – and consult with an accountant as to whether you should make an S corporation election (and then convert to a C corporation down the road). I discuss the issue of choice of entity in detail in my blog post “Choice of Entity for Entrepreneurs.”

3. Place of Incorporation. Some entrepreneurs make the mistake of incorporating the company in the wrong state. You should incorporate in Delaware – that’s what investors generally require. You should then qualify the company to do business in California and/or any other State in which it is “doing business.” I discuss this issue in paragraph 1 of my blog post regarding formation issues (part 1).

4. Vesting Restrictions. Some startups make the mistake of issuing stock to co-founders without imposing vesting restrictions. Then, one of the founders ends-up leaving in a few months and keeps all of his or her equity. You should make sure you and your co-founder execute a restricted stock purchase agreement with reasonable vesting schedules (typically four years) upon the issuance of the company’s stock. I discuss this issue in detail in my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

5. Securities Law Issues. Some startups make the mistake of not complying with applicable securities laws; for example, they issues shares to “friends and family” who are not “accredited investors” without proper disclosure documents; or they retain a consultant who is not a registered “broker-dealer” to sell company stock for a commission. You should be very careful when issuing any kind of securities; non-compliance could cause severe consequences, including a right of rescission for the securityholders (i.e., the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution. I discuss these issues in detail in paragraphs 2 and 4, respectively, of my blog post “Five Common Mistakes Entrepreneurs Make in Raising Capital.”

6. Splitting Equity. Some startups make the mistake of splitting equity equally between or among the co-founders. The splitting of equity is a significant business decision which must be negotiated between or among the co-founders based upon their respective contributions to date and their expectations going forward. Simply dividing the shares equally may sound fair on its face, but it’s usually not the correct decision. I discuss this issue in detail (and the various factors to consider) in my blog post “Ask the Attorney – Splitting Equity.”

7. Employment Issues. Some startups make the mistake of not addressing employment-related issues with respect to new hires. For example, if an employee is hired by a startup, he or she generally should be required to execute two documents: (i) an offer letter and (ii) a confidentiality and IP/invention assignment agreement. The offer letter will set forth all of the employee’s respective rights and obligations, including position, compensation (including stock options and/or other incentive compensation), benefits and, most importantly, whether the relationship is “at will.” The confidentiality and IP/invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by the employee is legally owned by the company. I discuss this issue in paragraph 8 of my blog post “Launching a Venture: Ten Tips for Entrepreneurs.”

8. 83(b) Elections. Some founders make the mistake of not making an “83(b) election” in connection with the restricted stock (i.e., stock subject to forfeiture) issued to them. Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock to the grant date, rather than the vesting date. As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low or would be equal to the purchase price if such stock was purchased), with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale. Such an election is made by filing the appropriate IRS form within 30 days after the grant/purchase date (no exceptions applicable). I discuss this issue in detail in paragraph 3 of my blog post “Founder Vesting: Five Tips for Entrepreneurs.”

9. Due Diligence. Some startups make the mistake of not diligencing the guys or gals on the other side of the table. Indeed, whether a startup is doing a financing, a partnering agreement or some other transaction, it must investigate the other party or parties involved. This means determining the reputation of both the company/firm (if it’s not a marquee name) and the particular individuals with whom it is dealing. Who are these guys? Are they good guys or are they jerks? Can they be trusted? When they say they are going to do something, do they do it? Do they add value? Remember, in certain deals (such as an angel or venture capital financing), the startup will, in effect, be married to the firm and the individuals for a number of years. I discuss this issue in paragraph 1 of my blog post “Five Mistakes Entrepreneurs Make in Dealmaking – Part I.”

10. LegalZoom. Finally, some startups make the mistake of using LegalZoom or other sites to prepare their legal documentation. Websites like LegalZoom are not law firms and do not render legal advice; nor are they able to create the kind of sophisticated documents that you need to protect yourself and to demonstrate credibility with your prospective investors. You should retain an experienced corporate lawyer to help you from the legal side. I discuss this issue in detail in the FAQ’s section of my website.

Conclusion

I hope the foregoing is helpful. I realize it’s a lot of information to digest; however, I see these mistakes made by startups all the time. Please shoot me any questions you may have in the comments section. Many thanks, Scott

10 Responses to ““Ask the Business Attorney” – What Are the Biggest Legal Mistakes that Startups Make?”

If you are originally a non-U.S company, I have heard from a good source that on an acquisition you are in a much better position if you have not yet incorporated in the U.S. The reason was that it is not possible to have the flexibility in tax reduction that you would have if you haven't incorporated in the U.S. Do you have any comments on this?